Tax planning amid elevated interest rates and limited interest expense deductions

Executive summary: Businesses are managing interest expense amid market and policy uncertainty

A combination of elevated interest rates and unfavorable tax rules governing deductions of interest expense has effectively increased financing costs for businesses since those factors coalesced in 2022. Some taxpayers have since found relief through planning opportunities and by using modeling to manage cash flows. 

In 2025, as Congress pursues significant tax legislation, it is considering a more favorable business interest deduction limit. Although there is support for a more favorable limit, the cost of a more favorable rule will factor heavily in whether Congress enacts it.

Given that uncertainty, there are several things businesses can do to address their borrowing strategies and debt structures in preparation for different policy outcomes.

This article. originally published on July 19, 2022, has been updated to reflect market conditions and tax policy developments.

An expensive coincidence: Rising interest rates and a law change

In 2022, several market and tax policy factors combined to increase the cost of debt for businesses. That dynamic has remained challenging.

As the United States in 2022 experienced its highest inflation rate in 40 years, the Federal Reserve raised interest rates to their highest levels since before the financial crisis of 2007–09.

This coincided with a previously scheduled tax law modification limiting the deductibility of business interest. The timing proved to be problematic, particularly for companies that traditionally rely on debt financing. Those companies faced rising interest costs while the tax benefit of their interest deductions diminished under section 163(j).

Specifically, the former add-back for depreciation, depletion and amortization previously allowed in the section 163(j) computation does not apply for tax years beginning after Dec. 31, 2021. This was an automatic change to the tax code that Congress scheduled back in 2017 when it enacted the Tax Cuts and Jobs Act (TCJA).

Businesses’ ability to plan around this stringent rule has depended on factors such as what industry they operate in and their preferred financing methods. 

The section 163(j) business interest limitation

Section 163(j) generally limits a taxpayer’s business interest expense (BIE) deductions to the sum of the following:

• 30% (50% for some years) of the taxpayer’s adjusted taxable income (ATI)
• Its business interest income
• Floor plan financing interest, which generally is interest expense on certain debt funding vehicle inventory purchases

A taxpayer cannot deduct the portion of its BIE that exceeds the limitation for a given year. Instead, the taxpayer may carry forward this so-called excess BIE indefinitely, testing its deductibility each year under section 163(j). If the taxpayer is a partnership, however, it does not carry forward the excess BIE. Instead, the excess BIE is allocated to the partners of the partnership, and the partners may carry it forward indefinitely.

These rules apply broadly to all taxpayers, with limited exceptions for businesses in specific industries. For example, certain farming and real estate businesses are excepted from section 163(j) on an elective basis. In addition, certain public utility businesses are exempted from section 163(j) on a mandatory (nonelective) basis.

There also is a small-business exemption from section 163(j) for a business whose gross receipts, together with gross receipts of certain related parties, do not exceed a threshold on a three-year-average basis (the threshold is $31 million for 2025 and is indexed for inflation).

Section 163(j) ATI computations became similar to EBIT instead of EBITDA

As noted above, a taxpayer’s limitation generally is based on 30% of its ATI. In common business parlance, ATI approximated earnings before interest, income tax, depreciation and amortization—EBITDA—for tax years beginning prior to Jan. 1, 2022; however, it changed to an approximation of earnings before only interest and income tax—EBIT—for tax years beginning after Dec. 31, 2021. (Note that ATI is computed under federal income tax rules, while EBITDA and EBIT are not.)

In other words, the so-called add-back of depreciation, depletion and amortization in computing ATI no longer applies for tax years beginning after December 2021. Applying the EBIT-like ATI computation results in lower ATI, a lower limitation, and lesser allowed tax deductions for interest expense for many businesses.

Planning strategies to counteract a loss of tax deductions

Businesses have a number of ways to improve their tax position in the face of more stringent interest limitation deductions. Which strategies are available to a given business depend on factors such as the industry the business operates in and the business’s preferred financing methods. Strategies that may be worth considering include:

1. Employing preferred equity financing rather than debt financing
   Because investors’ preferences are a major factor in choosing financing methods, businesses’ ability to switch to preferred equity financing varies widely.
   
   
2. Sale-leaseback structures
   A sale-leaseback often can be treated as a sale for tax purposes, even if it’s treated as financing (i.e., as debt) under generally accepted accounting principles. A detailed examination of the facts and circumstances is necessary to determine whether the transaction is treated for tax purposes as a sale and lease, or as secured financing. If the transaction is treated as a sale and leaseback for tax purposes, payments under the lease generally would be characterized as tax-deductible rent, which is not subject to limitation under section 163(j). 
   
   
3. Capitalizing interest expense
   Businesses may also consider opportunities to electively capitalize interest expense as part of the cost of property acquired or produced—to inventory or depreciable assets, for example. The capitalized interest expense then generally is recovered through cost of goods sold or depreciation and is not subject to the section 163(j) tax deduction limit for interest expense.
   
   
4. Beware of certain related party loans
   Certain loans between related parties, particularly so-called brother-sister companies, may result in taxable interest income for the lender and section 163(j)-disallowed interest for the borrower. Although documenting a loan is relatively simple, taking the simple approach may yield a tax problem.
   
   
5. Acquire partnership interests rather than directly acquiring business assets
   Increased interest expense deductions may be allowable after an acquisition structured as a purchase of a partnership interest when compared to one structured as a purchase of business assets. In lieu of amortization or depreciation expense for the partnership, this structure typically produces adjustments based on amortization or depreciation at the partner level.
   
   This structure would produce an increased interest deduction for the partnership in many cases, but also could have a downside in some cases.
   A good practice is to look before you leap. We recommend analyzing whether amortization and/or depreciation would be more beneficial at the partnership level or at the partner level, based on the facts of the particular transaction and the various tax rules that apply to it.
   
   
6. Elections for real property and farming businesses
   Congress provided elective exceptions from the section 163(j) limitation for a real property trade or business and for a farming trade or business. Taxpayers conducting an eligible business of one of these types may elect to except it from the section 163(j) interest deduction limitation; the election does not apply to any business ineligible for the exception. The election generally is irrevocable.
   
   Many businesses eligible to make this type of election have already done so. A taxpayer conducting a business of one of these types with no election in place may find making the election advantageous.
   
   
7. Depreciation method elections
   Accelerated depreciation methods for property used in a business can be very beneficial. However, removal of the section 163(j) add-back for depreciation, depletion and amortization provides a downside to accelerated depreciation. Decisions regarding depreciation methods should take the taxpayer’s section 163(j) interest deduction limitation into account. 

Tax policy outlook: Deductibility of business interest expense

Congress in 2025 is pursuing tax legislation at a scale which has not been seen since the TCJA in 2017. Republicans in the U.S. House of Representatives drafted a bill in mid-May that addresses tax rules expiring at the end of 2025 and proposes changes to existing business tax provisions. 

Among the existing business provisions subject to change is the relatively stringent limitation on the interest deductions under section 163(j). House Republicans have proposed reverting to the EBITDA-based calculation for ATI. The outcome may depend in large part on the cost, given the budgetary pressures and parameters at play in tax policy processes.

In the meantime, businesses that model out how more favorable interest deductibility provisions would affect their investment and financing strategies can position themselves to act accordingly once policy outcomes come into focus.

The takeaway: How would more favorable interest deduction rules affect you?

Many businesses since 2022 have experienced greater interest expenses due to increased interest rates. At the same time, many have seen a decrease in their tax deductions for interest expense. Now, there may be some relief on the horizon as Congress pursues another round of tax legislation.

Tax planning may provide some relief from the increased stringency of the interest tax deduction rules. Taxpayers that work with their tax advisors to model out the impact of these rules and various tax policy outcomes can effectively manage cash flows and align investment and financing strategies accordingly.